By: Jeff Anderson
|Close||Weekly return||YTD return|
|US Treasury 10yr Yield||3.891%|
Source: Wall St. Journal
It was another Yogi Berra week. Yogi was famous for his one-liners. “It’s like déjà vu all over again” is one his most quoted. It’s an appropriate quote for this week’s market behavior. The market keeps trying to front-run economic data that would support a Fed pivot. Pivot? Yeah, pivot, meaning the Fed would see fit to stop aggressively raising rates. Lower rates should be good for risk assets. Or at least a stop to the rate hike path they’re on. Today’s employment data hit traders overt head again, showing resilience in the face of a tough economic environment. The labor market isn’t slowing enough, and people are leaving the job market, decreasing the labor participation rate again. Its just not what traders wanted. As a result, the dramatic rise in markets on Monday and Tuesday were almost erased. We’ve witnessed this whipsaw action for months now.
We are close to kicking off 3rd quarter earnings season. Traders are waiting with bated breath for the results. Earnings are slowing…at least that’s the prediction. How much slower might be one question. An even more important question would be what does the fourth quarter look like? What kind of guidance might the over-paid corporate CEOs give? It would be a stretch to think they’ll be upbeat. Cautiously optimistic maybe? Possibly. If you’re an energy executive, earnings should be good, and the message should be positive. If you’re a consumer discretionary CEO, the mood may not be so rosy. CEOs in different industries will have their own set of challenges and opportunities to deal with, and more importantly, communicate with investors. How the market respond is really a matter of what expectations are going into earnings versus what expectations are after earnings. At a high level, it isn’t a stretch to think there’s at least a hint of pessimism heading into earnings. If things are even less pessimistic, the markets could rally. If investors can adjust their lens to look at the bigger, long-term picture, one quarter will look rather blurry and unimportant relative to the long-term view.
Comparing Personal Finance to Oil Companies?
Oil tycoons of the past never turned down the opportunity (& risk) of digging a dry hole, so the saying goes. How can the behavior of oil companies teach us about personal finance? Plenty apparently. Years ago (specifically – 2011 to 2014) oil prices remained steady at $100 to $110 per barrel, just as we’ve observed this year. Despite those prices, oil companies bled money. Free cash flow was negative. Free Cash Flow for oil companies is really the same as a household calculating how much money was saved over the year when comparing income to expenses. Households may have been making good money, and even received a raise or two along the way yet this bump in income was more than offset by an even higher level of spending. Hence free cash flow negative.
Great, but where is this going? Things changed….for the better. And it didn’t take a raise. It just took financial discipline. Oil companies got religion. Financial discipline was forced on them. The capital markets (the people who have the money to invest or lend to energy companies) were tired of handing over cash to spend-a-holics. Taking all that cash from drilling and buying more land, digging dry holes, and applying a rinse and repeat behavior became too much to take.
The message was clear. “We are demanding that you get your financial house in order.” Take that cash flow and do a few things with it. One, pay down your high-cost debt and get your debt levels to an appropriate level. Two, start paying a higher dividend. Three, buy back some of your shares. And then, and only then, go and invest some of that excess cash into replenishing your reserves. And that’s exactly what has happened. Financial discipline, whether forced upon you or from a change of behavior stemming from the stark realization that the current path is unsustainable is what the doctor ordered. See the parallels?
If you look at the chart, there are three pieces of data. The grey area shows the production of oil over the past 12 years. The blue line is the hypothetical growth of investment in the S&P 500 Index. The orange line is the hypothetical growth of investing in the energy sector of the S&P 500. See how the blue and orange lines diverged around 2014? Consistent negative free cash flows from energy companies had a material effect on your money if you invested in those companies. Only after they got religion and started behaving like the stewards of capital they should have been all along, did that sector start to earn decent returns. Getting a household to employ the same game plan will create the same thing. More money left over to invest or save for a rainy day in addition to not depleting your assets so they can compound will get households looking more like the right side of the chart.
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